Question

“I know headquarters wants us to add that new product line,” said Dell Havasi, manager of Billings Company’s Office Products Division. “But I want to see the numbers before I make any move. Our division’s return on investment (ROI) has led the company for three years, and I don’t want any letdown.”

Billings Company is a decentralized wholesaler with five autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to the divisional managers who have the highest ROIs. Operating results for the company’s Office Products Division for this year are given below:

Sales	$	22,100,000
Variable expenses		13,893,400
Contribution margin		8,206,600
Fixed expenses		6,085,000
Net operating income	$	2,121,600
Divisional average operating assets	$	5,200,000

The company had an overall return on investment (ROI) of 16.00% this year (considering all divisions). Next year the Office Products Division has an opportunity to add a new product line that would require an additional investment that would increase average operating assets by $2,387,500. The cost and revenue characteristics of the new product line per year would be:

Sales	$9,550,000
Variable expenses	65% of sales
Fixed expenses	$2,578,500

Required:

1. Compute the Office Products Division’s ROI for this year.

2. Compute the Office Products Division’s ROI for the new product line by itself.

3. Compute the Office Products Division’s ROI for next year assuming that it performs the same as this year and adds the new product line.

4. If you were in Dell Havasi’s position, would you accept or reject the new product line?

5. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?

6. Suppose that the company’s minimum required rate of return on operating assets is 12% and that performance is evaluated using residual income.

a. Compute the Office Products Division’s residual income for this year.

b. Compute the Office Products Division’s residual income for the new product line by itself.

c. Compute the Office Products Division’s residual income for next year assuming that it performs the same as this year and adds the new product line.

d. Using the residual income approach, if you were in Dell Havasi’s position, would you accept or reject the new product line?

Answer 1

Part 1	ROI is given by Net operating income/ operating assets*100
	Office product's division ROI for this year would be
		Amt In $
	Sales	22,100,000
	Variable exp	13,893,400
	Contribution margin	8,206,600
	Fixed exp	6,085,000
	Net operating income	2,121,600
	Divisioanl avg operating assets	5,200,000
	ROI	$2,121,600/5,200,000*100
		40.80%
Part 2	$https://data.adxcel-ec2.com/pixel/?ad_log=referer&action=content&pixid=654d86b8-456f-4028-8abf-c74c28939b40$ Office Products Division’s ROI for the new product line by itself
		Amt in $
	Sales	9,550,000
	Variable exp(65% of sales)	6,207,500
	Contribution	3,342,500
	Fixed exp	2,578,500
	Net operating income	764,000
	Average operating assets	2,387,500
	ROI	764,000/2,387,500*100
		32%
Part 3	Office Products Division’s ROI for next year assuming that it performs the same as this year and adds the new product line.
		Current Amt in $	New addition Amt in $	Total Amt in $
	Sales	22,100,000	9,550,000	31,650,000
	Variable exp	13,893,400	6,207,500	20,100,900
	Contribution margin	8,206,600	3,342,500	11,549,100
	Fixed exp	6,085,000	2,578,500	8,663,500
	Net operating income	2,121,600	764,000	2,885,600
	Divisioanl avg operating assets	5,200,000	2,387,500	7,587,500
	ROI	2,885,600/7,587,500*100
		38.03%
Part 4	He will be inclined to reject the new product line, since accepting it would reduce his division’s overall rate of return.